Practice Replacement Problem

Your assistant prepared an analysis of an investment opportunity the firm is considering. The investment involves purchasing a new machine that would replace an older, less efficient, machine. This replacement is expected to generate significant cost savings. The assistant$$s

analysis he presented to you follows:

REQUIRED ORIGINAL INVESTMENT

New machinery $$350,000$

Research and development $90,000$

Administrative time $30,000$

Total investment $$470,000$

DIFFERENTIAL ANNUAL AFTER TAX CASH FLOWS

Savings in costs:

Labor $ $75,000$

Materials $80,000$

Variable Overhead $40,000$

Total Annual Savings $195,000$

Depreciation: new machine $($this is correct$)(58,333)$

Net Savings Before Taxes $136,667$

Less income taxes $(40\%)54,667$

Annual After Tax Cash Flows $ $82,000$

You knew to review the above analysis with caution, as your assistant has limited experience with analysis of these types of decisions and has been known to overlook relevant information as well as mislabel financial information. Accordingly, you decided to gather some additional

information, which is shown below:

Regarding the NEW machinery, you also learned that:

$$ it would have a $6$ year life with no salvage value anticipated

$$ it would indeed save $$195,000$ annually in pre$-$tax costs

$$ it would indeed be depreciated at the straight line rate of $$58,333$ per year $($the IRS does not

allow research and development costs nor administrative time to be depreciated$)$

$$ it would require periodic maintenance in years $4$ and $5$ of its life, costing $$30,000$ in each of the two years

$$ it would require an investment in Working Capital of $$70,000$

Regarding the EXISTING machinery, you also learned that:

$$ it has a current book value of $$66,000$

$$ it will continue to be depreciated at the current straight line rate of $$11,000$ for the remaining$6$ years of its life.

$$ it has a current salvage value of $$50,000$

$$ it will have a salvage value of $$15,000$ in $6$ more years.

You also discovered that your assistant$$s listed costs for research and development and for administrative time relate solely to this project and contain no allocation. These costs have been incurred already, so their amounts are certain.

Required:

Determine the differential after tax cash flows only for the time periods $0,1,4,$ and $6$ that would be used to conduct a net present value analysis examining the differential economic impact of purchasing the new machine versus retaining the old machine. Note that I am not asking you to compute the net present value, but simply to identify the differential after tax cash flows for certain time periods that would ultimately be used to do this. Thus, I have not given you an interest rate.

Time Period $ Differential After Tax Cash Flow

$0$ $$\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_$

$1$ $$\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_$

$4$ $$\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_$

$6$ $$\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_$